Fixed-Income Fever

Amazingly enough, BGI's iShares have been the only choice for fixed-income ETFs for many years. With a miserly half dozen funds, the fixed-income universe for ETF investors was limited to shades of gray rather than a full palette of options. In early 2007, BGI expanded the number of funds it offers to a total of 15 and more than doubled the existing fixed-income ETF universe.

Competitors are catching the fever and are champing at the bit to add more funds. There are already enough fixed-income funds in the works to soon bring the total offerings to two dozen. The analysis necessary to find an appropriate fund has expanded with the number of choices.

Today's menuWith its recent fixed-income ETFs, BGI now offers fixed-income funds clustered in the Treasury, corporate, and mixed security markets and one asset-backed fund. There are seven iShares funds that cover the spectrum of U.S. Treasury securities. Investors looking for a little higher yield have one investment-grade corporate bond fund to choose from. Then there are three credit bond funds and two government/credit fund options. Those investors who want to mix it all together have one aggregate bond fund to select from. Finally, a mortgage-backed securities fund is the latest addition to BGI's lineup, and a high-yield fund is in the registration queue at the SEC.

General risk considerationsAlthough bond funds are usually considered to be more conservative investments than stock funds, they do have risks. Interest rate changes are usually the most common risk that bond funds face. When interest rates rise, bond fund prices will fall, and when rates fall, bond fund prices will rise.

With an investment in a fixed-income ETF, there are two components to your return: income from coupon payments, and capital gains from a change in the value of your principal. If coupon payments are fixed, that component of your return will not change over the life of the bond. Principal values, on the other hand, can change with fluctuations in interest rates or in the event of credit risk changes (for example, a downgrade or default).

As the yield of the fund goes up, it's usually safe to assume that the risk is going up as well. The hierarchy of risk can be generalized to start fairly low with treasury securities and then move up with corporate bonds.

U.S. Treasury ETFsCurrent treasury funds range from the very short-term iShares Lehman Short Treasury Bond Fund (NYSE: SHV) , to a 20-year-plus fund. In between are funds that offer investors the ability to incrementally increase their treasury exposure by three years at a whack up to the 10-year point. There's one fund that covers the 10- to 20-year treasuries, and another for treasuries beyond 20-plus years.

Sometimes there's a misplaced belief that U.S. Treasury bonds are completely safe. While it's true that these securities, and the ETFs that invest in them, have the government's guarantee of timely interest and principal payments, there's no guarantee against losses that result from rising interest rates. If interest rates rise, bond and ETF prices will fall. Short-term bond funds don't lose as much value in a rising interest rate environment. This means that when you pick a 20-year U.S. Treasury ETF, it will have more interest rate risk than a short-term treasury. Of course, that risk works for you when rates fall, as the treasury bonds and ETF prices will rise.

For those investors worried about inflation, BGI offers a treasury fund that invests in inflation-protected securities, the iShares Lehman TIPS Fund (NYSE: TIP) . The underlying U.S. Treasury bonds in the fund adjust their coupon payments and underlying principal automatically to compensate for inflation as measured by the consumer price index. That means investors in the fund can have a reasonable measure of comfort that inflation will not eat away returns.

Corporate bond ETFsInvestors looking for a fund that invests in the most liquid, investment-grade corporate bonds have an easy decision to make since there's only one ETF to choose from -- the iShares iBoxx $ InvesTop Investment Grade Corporate Bond Fund (AMEX: LQD) . If you aren't so concerned about liquidity, there are three credit bond funds that invest in the investment-grade credit sector in three different slices: one to three years, one to 10 years, and anything greater than a one-year maturity.

Mixed optionsTwo of BGI's new funds are mixed government/credit funds options, which invest in U.S. government and investment-grade corporate securities. A more established standby is the iShares Lehman Aggregate bond Fund (AMEX: AGG) . This fund plays in the total U.S. investment-grade bond market sandbox.

Mortgage-based fundBGI recently added an ETF that invests in mortgage-backed bonds, the iShares Lehman MBS Fixed-Rate Bond Fund (AMEX: MBB) . This is the first ETF to offer investors exposure to asset-backed securities, and its uniqueness provides diversification benefits for investors. The fund is invested in triple-A securities.

One of the largest risks for mortgage backed bonds, along with some other asset-backed securities, is prepayment risk. For mortgages, this risk occurs when mortgages are paid off early. When interest rates fall and homeowners pay off their mortgages, mortgage-backed securities lose their source of interest. This means that the higher-yielding bonds in a fund are likely to be repaid first, and not only does the fund lose that high interest payment, but also the potential price increase in the bond is cut off when it's repaid.

Competition catching onVanguard has filed with the SEC to offer ETF shares on four of its bond index funds. The new offerings cover the whole market with a total bond index fund, along with three funds that break down the market into long-, short-, and intermediate-term. In keeping with its focus on low costs, the Vanguard funds will charge 11 basis points. The low expense ratio of these funds is well below the average of nearly 18 basis points for the iShares, whose fees range between 15 and 20 basis points.

Ameristock has also jumped into the line at the SEC and plans to launch five U.S. Treasury ETFs linked to the Ryan ALM indices. The Ryan indices are calculated from the returns of the most recently auctioned Treasury securities at each of the following maturities: 1/2/5/10/20. The funds will charge a competitive 15-basis point fee.

Bond funds can play a role in a diversified portfolio, but they're not without risks. If you have short-term investment goals, you may want to look at the fixed-income ETFs with shorter maturities to offset the potential market volatility. As with any investment, there's going to be a tradeoff, and with the lower volatility comes a subsequent lower yield. Those investors who can withstand greater potential price fluctuation and would like a higher yield may want to consider intermediate- or long-term funds. There are now many more choices for fixed-income ETF investors, and as can often be said in this area of the market, if you don't like the available funds, just wait.

Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or securities mentioned in this article. The Motley Fool has a disclosure policy.

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